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EC 201 Lecture Notes 7
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ECON 201 - Macroeconomics
Lecture Notes 7
Metropolitan State University
Allen Bellas
BB Chapter 12: Monetary Policy
Monetary policy refers to the practice of changing the supply of money in an economy to
try to influence growth, unemployment and inflation. Monetary policy generally has the
same goals that fiscal policy does.
Monetary policy is generally conducted by a country’s central bank. A central bank
serves the following roles:
1. It regulates a country’s banks
2. It serves as a bank for banks, that is, it is a place that banks keep their deposits on
reserve and it is a place that banks can go to for loans if they have insufficient reserves.
To be clear about this, if a bank falls short of necessary reserves, it must borrow money
to get enough reserves.
3. It controls the nation’s money supply and, thus, conducts monetary policy.
Just about all modern economies have central banks. They include (or did include)
Germany’s Bundesbank, Great Britain’s Bank of England and, in the U.S., the Federal
Reserve System.
The Federal Reserve System
The Federal Reserve is the central bank of the U.S. It is comprised of 12 district banks
and a large number of member banks.
The Federal Reserve system was created by the Federal Reserve Act of 1913.
The seven members of the Board of Governors are appointed by the President and
confirmed by the Senate to serve 14-year terms of office.
The primary responsibility of the Board members is the formulation of monetary policy.
The seven Board members constitute a majority of the 12-member Federal Open Market
Committee (FOMC), the group that makes the key decisions affecting the cost and
availability of money and credit in the economy.
The other five members of the FOMC are Reserve Bank presidents, one of whom is the
president of the Federal Reserve Bank of New York. The other Bank presidents serve
one-year terms on a rotating basis. By statute the FOMC determines its own organization,
and by tradition it elects the Chairman of the Board of Governors as its Chairman and the
President of the New York Bank as its Vice Chairman.
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The Board sets reserve requirements and shares the responsibility with the Reserve Banks
for discount rate policy. These two functions plus open market operations constitute the
monetary policy tools of the Federal Reserve System. In addition to monetary policy
responsibilities, the Federal Reserve Board has regulatory and supervisory
responsibilities over banks that are members of the System
The Federal Reserve System is self-funded. It generates income through lending money
to its member banks while paying no interest on reserves it holds.
Because the Fed is self-funded, it is very independent of the government and Congress.
This makes the Fed a very undemocratic institution. This is also tremendously important
to the health of our economy.
How the Fed Controls the Money Supply
The Fed has three tools at its disposal for controlling the money supply. They are, in
decreasing order of importance:
1. Open Market Operations – the buying and selling of bonds
2. The Discount Rate – the rate at which the Fed lends to member banks
3. Reserve Requirements – member banks’ required reserve ratios
1. Open Market Operations
Money that is inside the Fed is not in circulation. When money leaves the Fed, it enters
circulation and becomes part of the money supply.
So, if the Fed buys something (U.S. treasury securities, in particular) the money that it
pays for that thing leaves the Fed and enters circulation.
If the Fed sells something (again, U.S. treasury securities) the money that it collects on
the sale enters the Fed and leaves circulation.
The money that enters or leaves the Fed is a change in the monetary base and is also a
change in total reserves.
This is the basis for open market operations, the sale or purchase of U.S. government debt
by the Fed. When the Fed wants to increase the money supply, it buys bonds, so bonds
enter the Fed and money leaves the Fed. When the Fed wants to reduce the money
supply it sells bonds, so bonds leave the Fed and money enters it, leaving circulation.
Once the money leaves the Fed, the usual process of the money multiplier occurs and the
total increase in the money supply is equal to:
∆MS = ∆ Re serves × MoneyMultiplier
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The money multiplier depends in part on excess reserves and how much money people
choose to hold on to and not deposit in their bank, so the Fed has imperfect control over
the money supply.
The relationship between open market operations, interest rates and bond prices is given
by the graphs below. The key to understanding this is to remember that bond prices and
interest rates move in opposite directions.
When interest rates rise, bond prices fall.
When interest rates fall, bond prices rise.
When the Fed sells bonds, it increases the supply of bonds and reduces the money supply.
Increasing the supply of bonds should decrease their price, which is consistent with
higher interest rates. Reducing the money supply is also consistent with higher interest
rates.
When the Fed buys bonds, it reduces the supply of bonds and increases the money
supply. Reducing the supply of bonds should increase their price, which is consistent
with lower interest rates. Increasing the money supply is also consistent with lower
interest rates.
The Fed doesn’t directly control interest rates (other than the discount rate) but when it
conducts open market operations it usually does so with the goal of bringing the federal
funds rate, the rate at which member banks lend to each other overnight, to a certain
level.
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2. The Discount Rate
By changing the rate at which it lends to banks, the Fed can affect the amount of money
member banks borrow and put into circulation and, thus, can affect the money supply.
It may also be the case that a higher discount rate causes member banks to hold higher
levels of excess reserves as insurance against the possibility that they might have to
borrow from the Fed.
A lower discount rate will increase the money supply and a higher discount rate will
reduce the money supply.
3. Reserve Requirements
These are currently set at 10% and haven’t changed since 1992, according to the
textbook.
It would be insane to use these for monetary policy, but if the Fed wanted to, it could
increase the money supply by reducing reserve requirements.
How Monetary Policy Works
Monetary policy changes the supply of money and impact interest rates in the credit
market or the market for loanable funds.
The cost of holding money is the interest that could be earned on it, so at higher interest
rates, the quantity demanded is smaller.
The demand for money
There are three motives for holding money
-Transactions motive (effects of changes in the price level and GDP)
-Precautionary motive (for emergencies)
-Speculative motive (as a stable asset)
Anything that affects these motives will affect the demand for money
Things that affect the demand for money
-Price level
-GDP changes
-Financial innovations
-Expectations about other assets
-Uncertainty about the future
The effectiveness of monetary policy depends on the slope of the money demand curve.
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Changing Ms will change interest rates and shift AD
An increase in the money supply increases AD
A decrease in the money supply decreases AD
Paul Volcker
Paul Adolph Volcker (born September 5, 1927), economist, is best-known as the
Chairman of the Federal Reserve under United States Presidents Jimmy Carter and
Ronald Reagan. (from August 1979 to August 1987).
Volcker's Fed was responsible for ending the United States' inflation crisis of the early
1980s. This was achieved by constricting the money supply through a sharp increase in
interest rates. In addition to disinflation, this policy caused a severe recession and the
worst unemployment since World War II. By 1985 the economy was nearly back to full
employment, and inflation was considerably lower: from 9 percent in 1980 to 3.2 percent
in 1983.
Here’s the story as told by data from the Economic Report of the President
Year
1978
1979
1980
1981
1982
1983
1984
Real
GDP
4760
4912
4900
5021
4919
5132
5505
Price
Level*
48
52
57
62
66
69
71
Nominal
M1
356.9
381.4
408.1
436.2
474.3
520.8
551.2
Unemployment
Rate
6.1
5.8
7.1
7.6
9.7
9.6
7.5
*This is the GDP Price Deflator
Price
Real GDP Level
Year
Nominal
M1
% change
Unemployment
Inflation
in Real
Rate
Real M1 GDP
Rate
1978
4760
48
356.9
6.1
743.5
1979
4912
52
381.4
5.8
733.5
3.19%
8.33%
1980
4900
57
408.1
7.1
716.0
-0.24%
9.62%
1981
5021
62
436.2
7.6
703.5
2.47%
8.77%
1982
4919
66
474.3
9.7
718.6
-2.03%
6.45%
1983
5132
69
520.8
9.6
754.8
4.33%
4.55%
1984
5505
71
551.2
7.5
776.3
7.27%
2.90%
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Equation of Exchange
-Concept of velocity – how many times a year does a typical dollar change hands
- V = YP/M
- velocity equals nominal GDP divided by the money supply
-Percent changes and the equation of exchange
%∆M + %∆V = %∆Y + %∆P
where
M is the money supply
V is velocity
Y is real GDP
P is the price level
Quantity Theory of Money
The quantity theory of money consists of three parts:
1. Equation of exchange
2. Velocity is constant
3. Y doesn't change in response to a change in M
The result is that changes in the money supply only change price level.
EX: Imagine an economy where velocity is constant (so %∆V=0), and real GDP grows
at an average annual rate of 3% (so %∆Y=3%). Putting these numbers into the above
equation gives us a relationship between the rate of growth of the money supply (%∆M)
and the inflation rate (%∆P)
%∆M + 0% = 3% + %∆P
So, if the money supply grows at 3% each year, inflation should average 0%. Increasing
the money supply at a greater rate will, in this model, simply create inflation.
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Activist Monetary Policy
Activist monetary policy suffers from most of the problems that afflict activist fiscal
policy, except that the Fed acts with one voice and can act much more quickly than can
Congress and the president. The Fed is also fairly well insulated from political stuff, so it
can act in the best long term interest of the national economy.
Milton Friedman says that the Fed should abandon activist monetary policy and just let
the money supply grow at the same rate that the economy usually grows at, thus
eliminating uncertainty about the future growth of the money supply.
This has good implications for demand side shocks, but not supply side shocks.